Iceland Says It’s ‘Far From Defaulting’ as Junk Looms

Local properties are reflected in windows at the Kaupthing Bank in Reykjavik, Iceland, on Tuesday, Oct. 7, 2008. Photographer: Arnaldur Halldorsson/Bloomberg News

July 30 (Bloomberg) -- Iceland’s government said it’s a
long way off defaulting on its debt payments after Moody’s
Investors Service warned it may lower the island’s credit grade
to junk, arguing lenders could require state support.

Moody’s is “taking it too far,” Economy Minister Gylfi
Magnusson said in an interview yesterday, after the rating
service cut the outlook on Iceland’s Baa3 foreign currency debt
to negative. Moody’s said it will lower the rating to junk if a
June court ruling banning some foreign loans hurts the recovery
or forces the government to raise debt levels by bailing out the
banks.

The rating “is already lower than is merited; saying that
the grade could possibly be lowered further is undeserved,”
Magnusson said. “The Treasury is far from defaulting.”

Iceland’s foreign debt is graded junk by Fitch Ratings,
while Standard & Poor’s gives the island its lowest investment
grade. A June 16 decision by the Supreme Court, banning loans
indexed to foreign-exchange rates, may require the state to bail
out the banks a second time since 2008, Moody’s said. That would
add to the government’s debt burden, which will reach 150
percent of gross domestic product this year, the rating company
estimates.

“The magnitude of the banking system losses that will
result from the recent court ruling is not known at this time
but it is clear that Iceland still faces significant risks,”
said Moody’s analyst Kathrin Muehlbronner.

Payments, Reserves

The government owes 1.03 billion euros ($1.6 billion) this
year and next, including 273 million euros in interest payments,
according to the central bank. Foreign currency reserves rose to
573.1 billion kronur ($4.77 billion) in June, the bank said on
July 9.

Finance Minister Steingrimur Sigfusson on July 7 said the
June ruling may cost Iceland’s banks as much as $4.3 billion,
equivalent to a third of the island’s economic output. A July 23
decision by the District Court of Reykjavik to allow banks to
raise interest rates on loans affected by the Supreme Court’s
ruling may limit those losses to $1.1 billion, Financial
Supervisory Authority Director Gunnar Andersen said.

Some of Iceland’s lenders may be unable to meet the
regulator’s 16 percent capital adequacy requirement because of
the foreign loan ruling, Andersen said in a July 14 interview.
Magnusson said then his government would suffer a “severe
blow” if called on to recapitalize the banks, though he didn’t
rule out financial support.

Capital Injection

The June ruling may “require the government to inject
further capital into the banks as the only realistic provider of
additional capital,” Muehlbronner said.

Arion Bank, the successor to failed Kaupthing Bank hf,
Islandsbanki, which was created out of Glitnir Bank hf, and NBI,
the successor to Landsbanki Islands hf, said this month the
impact of the June court decision on their assets is unclear.

The District Court of Reykjavik’s ruling last week allowed
lenders to charge higher Icelandic rates instead of the
contractual rates first attached to the loans. That ruling was
based on a retail car loan. It’s unclear whether mortgage and
corporate loans affected by the June 16 ruling can take higher
interest rates.

“Certainly there’s risk involved if the contractual rates
are applied, but that’s a distant possibility,” Magnusson said.
“Although it might be prudent of those who evaluate the risk to
take that into account, I think that’s such a farfetched outcome
that I don’t think the grade can be predominantly based on
that.”

Icesave

At the same time, the government has yet to resolve a
dispute with the U.K. and Dutch on how to cover depositor claims
worth about $5.1 billion. Failure to settle the claims may
prompt the International Monetary Fund and other lenders to
withhold future disbursements, Moody’s said.

“It’s certainly uncomfortable to have” the depositor
claims, known as Icesave, “hanging over us,” Magnusson said.
“We’re still aiming to resolve that matter.”

The IMF on June 28 delayed its third review of Iceland’s
program until the beginning of September. The review had been
planned to take place in July or August.

“The financing that was supposed to come” with the IMF
program is “quite a bit behind schedule,” Magnusson said.
“This has delayed the process of taking bold steps in removing
the capital controls. That’s a disappointment, but we have to
work with it.”

Foreign Lending

Iceland’s financial crisis was exacerbated by banks that
borrowed in currencies such as Japanese yen and Swiss francs to
take advantage of lower interest rates, then repackaged them as
kronur loans for clients. The krona has lost 38 percent against
the yen and 30 percent against the franc since Sept. 15, 2008.
The government is struggling to pay down a gross debt burden
that will swell to 150 percent of economic output this year,
Moody’s estimates.

The prospect that Iceland’s economy will return to growth
next year is “subject to significant downside risks,” Moody’s
said. The economy contracted 6.5 percent in 2009 and will
probably shrink a further 2.6 percent this year, the central
bank estimates. Output will expand 3.4 percent in 2011, the bank
said in its latest forecast in May.

Moody’s said the June 16 ruling and Iceland’s failure to
resolve its depositor claim dispute with the U.K. and
Netherlands represent “significant and persistent
uncertainties” that have “the potential to undermine Iceland’s
recovery.”